Cliff Wachtel, CPA, is currently the Director of Market Research, New Media and Training for Caesartrade.com, a fast growing forex and CFD broker. He covers a variety of topics including global market drivers, forex, currency hedged and diversified income investing, and is currently working on a... More

The growing threat that political stalemate may actually cause the first US default ever really began scaring markets this week, and this fear was among the top market movers this past week. Much has been written about it. See here, here, and here for more details. Key points to consider from it all:

Political Deadlock Threatening US AAA Credit Rating? While most believe default still unlikely, the very fact that the US Congress has been unable to reach a deal has undermined global confidence in America’s ability to deal with its fiscal problems decisively, and that alone has raised the risks of at least a loss of the US’s AAA credit rating. Unlike the EU, the US demonstrated an ability to move fast when it prevented the Lehman Brothers bank collapse from becoming a global banking crisis. In the past weeks Congress has resembled the EU’s indecisiveness as politics overrides responsible fiscal decision making.

The consensus view remains that the US will avoid default either via a short term debt ceiling increase or other short term fix. This may spark at least a short term relief rally for the USD, at least until it starts getting hit with expected credit downgrades that would likely send the USD on a new leg lower, unless of course the EUR manages to look even worse, a realistic possibility as we’ll discuss below in the section on EU developments.

For perspective, businessinsider.com posted a great article and pie chart which essentially showed that there are very few really liquid AAA rated alternatives to US bond, especially once you toss out France and Germany, neither of which can really be considered AAA given that they’re not sovereign currency issuers and are heavily exposed to their very sub-AAA fellow EZ members. Here’s the chart.

The data confirms the weakness of the US recovery and feeds growing speculation about some form of QE3, despite the failure of QE2 to meaningfully improve America’s economy. As we’ve said before, providing more liquidity and low rates seems to be the wrong medicine for a balance sheet recession like this one, in which both businesses and consumers are cutting debt loads and spending less. Thus unless deflation becomes a problem we don’t see more stimulus coming in the near term

Of course, bad US data is no real surprise, merely further confirmation that the already weak US recovery is stalling out. With jobs growth and thus spending and housing stagnant or deteriorating, a “double dip” recession is looking more likely. That is, if you believe the first recession ever really ended outside of the financial markets.

EU: Not So Quietly Deteriorating

Unlike in the EU, the US’s debt trouble is purely a matter of political deadlock and is should be easy to solve in the short term (never mind actually making progress on America’s long term debt issues) once the will exists in Congress to do so. In contrast, the EU crisis appears far harder to solve, and the past week’s events showed that optimism over the latest Greek rescue has backfired and accelerated the risk of contagion infecting Spain and Italy.

LATEST GREEK RESCUE FAILS TO STOP EU CONTAGION FEARS

Evidence continues to build that the latest Greek rescue plan has failed to contain contagion threat. As we’ve warned for weeks, the new policy to impose losses on GIIPS bondholders, who had been lead to believe that the EU would keep them whole, has made GIIPS bonds far more risky, hence the rising yields. These in turn raise the risk of the very defaults the plan is trying to prevent – those of the too big to bail “game-over-for- the-EZ” dominos, Spain and Italy.

Austria and Italy both cancelled bond auctions on Monday due to higher rates and poor results. Both essentially claimed that they suddenly decided they didn’t need the money despite the long ago scheduled auctions were clearly planned to meet normal funding needs. The problem for Italy is that it will now depend on raising that much more money in its next medium term bond auction. See here for details.

Italian and Spanish bond yields continued higher this week.

Italian bank shares continued to fall and had trading briefly suspended last week due to sharp declines.

Friday was just plain disastrous for the EU. In addition to the risk-off energy provided by the bad US Q2 GDP figures :

Moody’s gave Spain the tough love, placing 5 banks (including stalwart Banco Santandar) on review for credit downgrade, and also warned it may cut Spain’s sovereign debt rating because that Spanish bonds remain above 6 per cent, and that Spain’s contribution to the second Greek bailout could add extra pressure on its already stretched public finances. Just a week after the latest Greek rescue plan was announced on July 25th, Spanish bond yields are back near record highs and the cost to insure Spanish debt against default has soared. Spain is now only 90- basis points away from the critical 7% threshold in 10-year yields. Once bond yields of Greece, Ireland and Portugal hit 7%, they escalated rapidly, ultimately leading to a de facto cutoff from credit markets and choice between an EU bailout or imminent default.

Could Moody’s also be sending a warning to the US of what will happen to US bank credit ratings once the US losses its AAA rating?

There were reports that the European Financial Stability Fund may not have the cash to loan Greece its next bailout tranche, partly because weaker contributing nations like Italy and Spain may not be able to afford their share of the payments, suggesting that a fund comprised of sub-AAA really is sub AAA.

No Other Real Market Movers

Data and even the key third week of US Q2 earnings failed to have major impact on market movements.

Ramifications & Lessons

The EU’s troubles are deeper, more intractable, and thus more long term than those of the US.

Fundamental Picture Remains Bearish

While the economic slowdown in both the EU and US will continue to weigh on risk appetite and limit rallies in risk assets, we expect the USD to continue its slow but steady gain vs. the EU in the weeks ahead, though that’s subject to the return of sanity and progress on the US debt ceiling impasse. This was once assumed, but now…?

Technical Picture: Cracks In Market Resilience Grow More PronouncedEquities: Using The S&P 500 As Representative Sample

DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING DECISIONS LIES SOLELY WITH THE READER. IF WE REALLY KNEW WHAT WOULD HAPPEN, WE WOULDN’T BE TELLING YOU FOR FREE, NOW WOULD WE?

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